Rent vs buy redux: Is buying a useful commitment device?

One of the things l love the most about having a blog is the way in which I often bring up a subject and then get a stream of commenters — many of whom know much more on the subject than I do — really move the topic forwards.

A prime example is my post from Friday on rent vs buy calculations, itself prompted by a previous comments stream. My back-of-the-envelope calculations only looked at the position after one year, but a number of commenters have looked out much further than that, and one even did a Monte Carlo simulation! What’s more, my commenters didn’t just pull numbers out of thin air, as I did, but gave me some very useful real-world datapoints.

Nicholas Weaver put a spreadsheet online for one property in California, assuming rent stays constant starts at $1325 a month and rises by 3% a year, and using a real-world purchase price of $400,000. Upshot? Renting was a lot cheaper. Now, he says, his rent is $1675, for a house worth more than $600,000.

And RichB, in England, came up with an even more elaborate spreadsheet for a UK place listed at ß£795,000 which is renting for ß£2750 per month. (Remember that the UK abolished mortgage-interest tax relief, with no appreciable effect on housing prices.) He assumed upkeep costs of 0.5% of the purchase price (about ß£330 per month), and rent rising at 3% per year. Again, renting was a lot cheaper than buying: if you held the house for 10 years and prices rose by 6% per year annualized that whole time, you’d still be ß£115,000 worse off by buying.

But. Buying is what economists like to call a “commitment device” — one of those situations where you can make yourself better off by reducing the number of options available to you. RichB, for instance, makes this crucial assumption:

The difference between the monthly mortgage payment and monthly rent, as well as all up front costs, are assumed to be invested at 5.5% (with a 40% tax rate).

This strikes me as both reasonable, in terms of the rent vs buy calculation, and also, at the same time, utterly unrealistic. People stretch themselves and bend over backwards and perform all manner of other metaphorical financial calisthenics to make their mortgage payments every month so that they can continue to live in their home. People buy homes at the outer edge of the affordability envelope because they value all that space and light and convenience in terms of commuting, and so on and so forth. No one will have the same kind of real and emotional attachment to a monthly plan involving paying a certain amount of money into a savings plan yielding 5.5% per annum. In other words, the difference between rent payments and mortgage payments, if the mortgage payments are higher, is not likely to get invested: it’s likely to get spent.

So maybe there’s a good reason why people buy houses even when it would be mathematically cheaper for them to rent: it’s a forced savings device. All that money they save and scrounge up for the down-payment; all that extra money they find every month for a mortgage payment which they wouldn’t bother doing if they were renting — it all goes towards building up equity in a very valuable home. Theoretically, they could do the same amount of savings with money rather than with property, but in practice very few people ever do. To take RichB’s example, after 10 years someone who bought the house would have hundreds of thousands of pounds of equity in his house. While someone renting the house would have memories of great holidays and meals at restaurants, and would have a spiffier wardrobe, but would have much less total net worth.

One nit: I actually assume inflation in rent, just at 3.5%/year or so.

And the commitment device is a good point. Myself, I actually do a fair amount with some auto-withdraws into my brokerage account, as well as the auot-commit into the 403b, but I know I’m the exception, not the rule.

It is interesting to apply the dividend discount model to housing. Rent increases in LA have averaged 5-6% for well over a decade. With mortgage rates also in that range, housing values, rents / (mortgage rates – rent growth), went hyperbolic as rates dropped. What goes up, can come down though, at least in real terms, as rates have risen, and growth slowed due to so many buying. Now rates have flattened and growth may pick up again since few can afford to buy.

People buy homes at the outer edge of the affordability envelope because they value all that space and light and convenience in terms of commuting, and so on and so forth

Absolutely true, and with interest rates so low an extraordinary number of buyers can afford the payments on an interest-only ß£600,000 mortgage. The consequence is that there are no houses left in London with space, light, good commuting etc for less than ß£750,000.

I can only assume that the traditional UK lending criteria of 3.5 to 4 times one income, or 2.5 to 3 times joint income, are simply not being commonly applied any more. There is just no way to stretch yourself financially when buying a home on those criteria with interest rates this low. A middling professional London couple earning ß£100,000 between them would, according to the banks’ public lending criteria, be able to borrow ß£300,000, which works out at about ß£1,600 per month (6.5%, interest only). Their monthly joint take-home pay would be around ß£5,800 so they’d still have ß£4,200/month for other expenses. That’s a lot of spare cash, and they’d have no reason not to save a large chunk of it.

Now in reality they’re not saving it in the traditional sense, they’re taking out a ß£600,000 mortgage or more and paying a truckload of interest for the next 25 years in the hope that their capital gains will outstrip the interest costs.

I am puzzled why anyone would question the advantage of owning. The advantage is called _control._

If I rented my house I would not have just taken up the shabby lawn and put in a patio.

I would also be worrying (for good reason as this has happened to friends of mine) that my landlord would evict me — with sympathetic notice — so that his daughter and new son-in-law coulod move in.

The benefits are in the enforced savings, to be sure, but they are primarily in a sense of security. Buying a house is not a business deal; improving it often makes no economic sense. (I doubt if my new patio could be recouped if I sold it next month.) So assessing its value in terms of alternative investments makes little sense.

A great discrepancy between buying and renting is totally rational when you factor-in — as the market does — the psychic value of not that it is yours (well yours, the bank’s and tax-man’s.)

Granted, there is some benefit in the enforced savings mechanism of taking out a large mortgage, but why should that benefit suddenly become so valuable as to explain the increasing discrepancy between purchase price and rent? 110,000 pounds is a lot of money to pay to be forced to save half your income for 10 years.

There are also benefits of being in control of a house you own rather than rent, but there’s also a downside to that. You can ask my landlord about that who just had to shell out to fix the roof on my house, eating up about three months of rental income.

It really is the change which is the shock, and what triggered my spidey sense.

I’ve done a lot of “put different numbers” in my spreasheet. EG, when my friend bought his house in the DC burbs in 2000-2001, the spreadsheet said “buy” in a hot second, (assuming >= 2 years job/location stability, because of the 6% transaction cost if you were forced to sell). Run the same numbers for 2005 and it was “rent” by a huge amount.

I live in the North of England and have a pretty cheap mortgage, about 1.5 times salary. Friends in London are paying through their collective noses to pay for their properties, upwards of 4 times salary.

Do I put all the spare cash I have from paying a cheaper mortgage in a high-interest account? Some of it, but nowhere near enough. The net result will be, in ten years time, I will have nowhere near the capital asset accumulation to move down south, should I so desire.